If you have been in the crypto world for any time, you have probably heard about airdrops – they are like unexpected bonuses and can be a real game changer in building wealth. An airdrop is a free distribution of tokens to qualified users based on the project’s specific requirements, such as using a decentralized exchange or holding a specific coin. Think of it as a project's way of saying 'thanks for being with us' and a clever tactic to get people excited about a new coin.
Remember the Uniswap token airdrop? That was huge and allowed the UNI token to gain traction very rapidly. While we had not seen many airdrops throughout the extended bear market, this new cycle is starting to heat up when it comes to airdrops. Recently, many Solana projects have been dropping tokens like PYTH, and industry experts predict that airdrop season is just getting started.
But here's the catch: while it feels great to get these freebies, the Internal Revenue Service (IRS) is also paying attention. The guidance provided specifies that airdrops are taxable, just like regular income. That means you have to consider the value of these tokens right when they land in your wallet. This is critical to remember when you consider that the IRS is aiming to crack down on non-compliant crypto investors.
Understanding Airdrops: Definition and Mechanism
So, how exactly do airdrops work? The name ‘airdrop’ could not be more accurate than what it represents. From a crypto user’s perspective, it seems as if tokens were dropped out of thin air into your wallet. When you receive an airdrop, it feels like you just received something for free in return for nothing. But airdrops are not just random; there is a method to the airdrops.
Projects usually have a list of things you must do to be eligible for the airdrop. It might be as simple as holding a particular cryptocurrency, using a specific dapp, or being active in their community. Sometimes, you might need to follow them on social media or sign up for their newsletter. The twist is that you don't always know these requirements upfront. Some projects keep them under wraps until the airdrop happens, giving a surprise bonus to active users.
This approach is a clever move for crypto projects. It's not just about being generous; it's a solid strategy to get their token out there, create some buzz, and build a community of interested and invested users. By spreading their tokens far and wide, they're not just gaining immediate attention but setting the stage for a more decentralized and engaged user base.
Airdrop Farming and Security
The term ‘airdrop farming’ has become popular as of late. This involves crypto investors, more often on the degen end, anticipating projects that might have upcoming airdrops and attempting to fulfill the requirements to qualify for as many as possible. While the payouts can be lucrative - receiving free coins without having to give up anything else, you should be cautious of who you trust, what platforms you choose to interact with, and which wallets you use to try to earn these airdrops.
For example, a recent airdrop farming strategy has been making its rounds on social media. This strategy involves staking SOL on Marinade to receive mSOL and lending (and borrowing) the mSOL on Drift and Kamino. This is all in anticipation that these platforms will airdrop their token in the near future to those users who used the applications and provided liquidity. But what happens if you provide liquidity to a project that turns out to be a scam? What if you get stuck with a token with no value, lose your original coins, and the airdrop never comes? What if the wallet you chose to connect to the platforms is your main wallet, and it gets hacked?
There are many risks in airdrop farming, and you should DYOR the same as you would for any other project you choose to invest in. Do not ape into a project just because someone on social media tells you it will be the next $20k airdrop. Also, be cautious and never use your main crypto wallet to connect to these platforms - ask anyone in the past who has had their wallets drained after inadvertently interacting with scam platforms. Remember, capital preservation is first, alpha is second. It is extremely easy to fall victim to a scam and lose a lifetime of accumulated wealth in minutes.
Case Studies: Uniswap and Solana Airdrops
The Uniswap airdrop is one of the most talked-about events in the crypto world. In September 2020, Uniswap, a leading decentralized exchange, made a groundbreaking move by distributing its native UNI token to past users of the platform. Approximately 400 UNI tokens were airdropped to each user who had interacted with Uniswap before a certain date. This wasn't just a generous giveaway; it was a strategic move to decentralize the platform's governance, giving users a say in its future development.
The impact of this airdrop was significant. Not only did it reward early adopters and loyal users, but it also spiked interest in the Uniswap platform. The value of the UNI token saw substantial growth shortly after the airdrop, benefiting those who held onto their tokens. From a tax perspective, this event posed interesting questions regarding the valuation of airdropped tokens and the timing of their income recognition.
The recent hype surrounding airdrops has been driven by Solana and its ecosystem. Various Solana projects have leveraged airdrops to build their communities and distribute tokens. Some examples of recent Solana airdrops include Jupiter (JUP), Pyth (PYTH), Jito (JTO), and BONK. These recent airdrops, along with the increased growth of the Solana ecosystem, have led to many crypto investors trying to farm future Solana airdrops or even anticipating what the next ecosystems to join the airdrop party will be.
These airdrops have rewarded users and played a crucial role in expanding Solana's user base and increasing token circulation. They not only help the projects issuing the airdrops but also the underlying blockchain that they are launched on, such as Ethereum for UNI and Solana for the latest airdrops discussed, as airdrop farmers enter the ecosystem to attempt and qualify for future airdrops.
The IRS Perspective: Tax Implications of Airdrops
The IRS first issued guidance on airdrops in 2019 with Rev. Rul. 2019-24, when it stated that “a taxpayer has gross income, ordinary in character, under § 61 as a result of an airdrop of a new cryptocurrency following a hard fork if the taxpayer receives units of new cryptocurrency.”
This is the same answer that can be found in the IRS Frequently Asked Questions on Virtual Currency Transactions, question 23. It is important to distinguish between a hard fork and an airdrop, as the two are unrelated. The IRS Revenue Ruling focused primarily on coins received from a hard fork. While one can think of receiving coins following a hard fork as a similar event to an airdrop, as holding a certain coin or token before a hard fork generally leads the holder to receive seemingly free coins, from a crypto technical perspective, the two are different events.
Despite the error in the IRS communication with these technical terms, it does not make a difference as of today, as both new coins resulting from a hard fork and airdrops are considered ordinary income based on their fair market value at the time that the user obtains control of these coins. This means that the outcome is the same whether you obtained new coins (or tokens) as a result of a hard fork or airdrop for tax purposes.
Determining Fair Market Value: How to Assess Airdrops for Tax Purposes
The biggest challenge in reporting your taxable income from airdrops is determining the value of the airdrops. Oftentimes, airdropped tokens do not have sufficient volume early on, and thus valuation becomes difficult. Sometimes, these tokens are not even listed on CoinMarketCap or CoinGecko. Sometimes, tokens at such an early stage of their life experience extremely high volatility - much higher than established cryptocurrencies. This high volatility can create confusion as to the valuation at which you should report your airdrop. What if the tokens you got airdropped 10X in price within the first day, but you don’t claim your airdrop until after this increase in price? What if you claimed them prior to the price increase, but the crypto tax tool you are using does not have the right pricing due to how new the tokens are?
One key distinction you must understand prior to reporting your income from airdrops is that you must have actual control of your tokens to claim the income. Simply being eligible for an airdrop does not constitute a taxable event. The taxable event is when the tokens get distributed to the user, and the user gains control of them. This means that if you qualify for an airdrop, but there is something you have to do to claim the tokens, the airdrop is not taxable until you actually claim the tokens and you have control of them. This is obviously different for airdrops that are just sent to your wallet, which are taxable at the time of receipt (i.e., control).
So the key to properly valuating your airdrops is to figure out the exact date and time you obtained control of the tokens and look at their actual value. Do not rely on what your crypto tax software tells you, as there can be significant differences. There could be time zone issues that your tool thinks you got the tokens at a different time, or the tool could be using an API from a site like CoinMarketCap to obtain pricing, and if pricing isn’t available early on, or if the tool only fetches pricing data every 30 minutes, there is a high likelihood that your airdropped tokens will be valued at the wrong price.
Keep in mind that the income you report from your airdrop also becomes your tax basis in such tokens. So later on, when you sell them, you will only pay tax on the profit over the tax basis. To illustrate, if you receive $1,000 worth of an airdrop and thus report $1,000 as income, then you later sell the tokens for $5,000, you will report a $4,000 taxable gain ($5,000 - $1,000). In other words, with airdrops, you will always pay tax on 100% of your income and gains but never double tax. If this is the case, why does valuation matter? This is because ordinary income (from airdrops) cannot be offset by capital losses. Suppose you have $5,000 in capital losses from other trades. If you report properly $1,000 airdrop income and $4,000 capital gain, your capital gain of $4,000 will be completely offset by your $5,000 in capital losses. If you had reported $5,000 of airdrop income (if you didn’t properly value the tokens) and $0 capital gain, then your $5,000 capital loss would only offset $3,000 of this income. The point is that the difference between ordinary income and capital gain can substantially impact your tax liability.
Tax Reporting for Airdrops: Navigating Compliance
Once you have properly valued your airdrop income, how do you report this income when preparing your individual income tax return? In the future, it is possible that there will be a separate schedule to report crypto-related income, but this is purely speculation. For the time being, you will want to report this on Schedule 1, line 8z, as ‘other income.’ Suppose you use a retail tax tool like TurboTax or H&R Block. In that case, you will want to navigate to the ‘other income’ or ‘miscellaneous income’ sections and manually enter ‘other income’ with a description such as ‘airdrop income.’ Word of caution: make sure you enter this as other income not subject to self-employment tax, or you will pay a higher rate than you should.
Conclusion
Airdrops are a fantastic opportunity for crypto investors to accumulate wealth by being in the right projects early on, but you must remember that there are tax implications when you do claim these airdrops. While the reporting may seem fairly straightforward, you must be careful with highly volatile tokens and bad data, or you may be overpaying your tax bill. If you need help with your airdrop reporting and overall crypto taxes, CryptoTaxAudit has a team of expert crypto accountants ready to help you navigate these complexities.
